Friday, May 9, 2008


"Over the last decade, Moody's and its two principal competitors, [S&P] and Fitch, played this game to perfection--putting what amounted to gold seals on mortgage securities that investors swept up with increasing elan. ... No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and--their capital thus replenished--wrote new loans at a much quicker pace. ... Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street. ... Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and [S&P] that set the credit standards that determined which loans Wall Street could repackage and, ultimately which borrowers would qualify. ... Arthur Levitt, the former chairman of the [SEC], charges that 'the credit-rating agencies suffer from a conflict of interest--perceived and apparent--that may have distorted their judgment, especially when it came to complex structured financial products. ... Moody's did not have access to the individual loan files. ... 'We aren't loan officers,' Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody's told me. 'Our expertise is as statisticians on an aggregate basis. We want to know of 1,000 individuals, based on historical performance, what percent will pay their loans?' ... Nearly half of the borrowers [in this pool], however, took out a simultaneous second loan. Most often, their two loans added up to all of their property's presumed resale value, which meant the borrowers had not a cent of equity. ... That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. 'People say, "How can you create triple-A out of B-rated paper?'" notes Arturo Cifuentes, a former Moody's credit analyst who now designs credit instruments. It may seem like a scam, but it's not. ... However elegant [structured finance's] models, forecasting the behavior of 2,303 mortgage holders is an uncertain business. 'Everyone assumed the credit agencies knew what they were doing,' says Joseph Mason, a credit expert at Drexel University. 'A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.' ... Moody's used statistical models to assess C.D.O.'s; it relied on historical patterns of default. ... Jamie Dimon, the chief executive of JPMorgan Chase ... says, 'There was a large failure of common sense' by rating agencies and also by banks like his. 'Very complex securities shouldn't have been rated as if they were easy-to-value bonds' ... The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. ... In effect, the government outsourced its regulatory function to three for-profit companies. ... As [Frank] Partnoy says, rather than selling opinions to investors, the rating agencies were now selling 'licenses' to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating--not its accuracy--that mattered to Wall Street. ... Nothing sent the agencies into high gear as much as the development of structured finance. ... According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, 'The whole creation of mortgage securities was involved with a rating.' What the bankers in these deals are really doing is buying a bunch of I.O.U.'s and repackaging them in a different form. Something has to make the package worth--or seem to be worth--more than the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers' fees. That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a lot of incentive to get over the line. The challenge to investment banks is to design securities that just meet the rating agencies' tests. ... 'Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,' a former Moody's expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, 'Gaming is the whole thing.' ... The evidence on whether rating agencies bend to the bankers' will is mixed. ... But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody's has thousands of clients. ... No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. ...And the banks pay only if Moody's delivers the desired rating. ... If Moody's and a client bank don't see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as 'ratings shopping.' ... James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. ... Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather it was the size of their first and second loans--that its, their total debt combined. ... Amy Tobey, leader of the team that monitored XYZ, told me, 'It seems there was a shift in mentality; people are treating homes as investment assets.' Indeed. And homeowners without equity were making what economists call a rational choice: they were abandoning properties rather than make mayments on them. ... A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does. ... 'We're structure experts,' Yuri Yoshizawa, the head of Moody's derivative group explained. 'We're not underlying-asset experts.' They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral. ... The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate", my emphasis, Roger Lowenstein (RL) at, 27 April 2008.

RL sees the rating agencies (RA) much as I do. The RA and CPA firms are in the same business, selling third-party certifications. Like the SEC requires audited financial statements of SEC registrants, the market requires ratings to sell mortgage-backed securities. RA sell borrowers licenses, CPA firms sell SEC registrants licenses. Like CPA firms, which try to disclaim, responsibility for finding fraud, the RA blame fraud too. The RA could have asked their CPA firms what do do when faced with "insufficient evidential matter" to support a rating. Walk away. Yoshizawa's comment is telling, she's not an "underlying-asset" expert. What then? An overpaid clerk using spreadsheets she does not understand? A "handful of banks". Have we a repeat player advantage here? The RA's fees must not be contingent on their ratings. They must be paid in advance. Every mortgage-backed security sold must have an originator "certificate" that the mortgages in it were not "cherry-picked". Violations of my no "cherry-picking" rule should be securities fraud. "Ratings shopping", oh no. RA look like CPA firms. Wow, a homeowner with no equity in his property sees his "ownership" as economically equivalent to owning a call option combined with a lease. Is Moody's so stupid, it didn't understand that? Yes, a CDO operates like a mutual fund. See my 15 November 2007 post in which Allan Sloan likens investment bankers to butchers. I add, overpaid butchers selling hamburger as filet mignon. See also my 8 November and 12 December 2007 and 2 February 2008 posts.

R&R Consulting's Ann Rutledge has two good posts at her blog, on 15 March and 5 April 2008 concerning securitization economics. She describes "five preferred (often inter-related) ways to mask the true credit condition of a structured bond". Unfortunately the system was gamed for years.

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